Journal / Article Review: A Comparative Study of the Returns on Mudharabah Deposit and on Equity in Islamic Banks

By Authors:

Abdou Diaw and Abdoulaye Mbow (International Centre for Education in Islamic Finance (INCEIF), Kuala Lumpur, Malaysia

Journal / Article Review:

This write is trying to review and analyze a research paper on “A Comparative study of the returns on Mudharabah deposit and on equity in Islamic banks”. The article is co-written by Abdou Diaw and Abduulaye Mbow of the International Centre for Education in Islamic Finance (INCEIF), Kuala Lumpur, Malaysia. As the paper title specifically mentioned, the aim of the authors are to compare the return on investment in the both type of instruments that are mudharabah deposit and equity in the Islamic banks.

The research was conducted based on samples collected from nine Islamic banks of seven countries. The source of samples although seems very small but actually represents a significant portion of the total global Islamic banking institutions as they are the major players in their own countries. The chosen countries where the banks operate are the early adopters and leading players of Islamic finance and banking systems.

The authors highlighted that mudharabah contract and equity share same profile in terms of risk but are different on how they are rewarded. This is very true if we look at the actual return rate Islamic banks give to its mudharabah account holders. This has raised a question of fairness and transparency to those depositors who bear the risk of losing their capital investment. They also tried to discover how the adoption of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) accounting treatment for mudharabah deposit affects on this account.

In finding the comparative results, the authors employed the risk-return framework and regression analysis method on a set of data from selected Islamic banks. The methodologies employed are suitable in testifying the theory of risk-return on Islamic investment products by using the regression analysis. The calculations obtained were used to compare the percentage of Return between the Mudharabah Deposit (ROMD) and Return on Equity (ROE).

The authors have a clear understanding on the relationship between risk and return which has a positive relationship. For example, an investment in mudharabah account exposes the investors to either profit or loss depending on the performance of the business ventures. The same principle applies to equity investment. The investment with similar risk profile should yield comparable return. Thus, both types of investments should receive same treatment in terms of the return on investment. They also made the understanding on the study easier for those who do not have fundamental knowledge in Islamic finance by relating the risk profile in investment from pure finance viewpoint. That is to justify reasonable expectations from depositors for similar returns on Mudharabah deposit and equity.

But the authors did not find any proof in their research that the Islamic banks upheld this principle. They found out that the average returns on Mudharabah deposit are corresponding with the local interest rates. As generally practiced, the normal conventional deposit receives interest based on local interest rate as the benchmark. The finding has caused a great concern especially for those who expect a higher return for their mudharabah deposit whereas the conventional saving accounts are riskless since the offering banks guarantee both return and principle. Consequently, this situation may affect the attractiveness of mudharabah deposit in Islamic banks as compared to conventional deposits.

As the writers pointed out the similarities in terms of risk profile between mudharabah deposits and equity from the finance theory’s on risk return did not applicable at Islamic banks in this research. Two investments were rewarded differently. The ROE behaved in as similar fashion of the theory but the ROMD seemed to mirror the local interest rates.

There is an interesting observation by the writers on the effect of lower return from mudharabah investment that could cause large fluctuations and frequent movement of the funds in the banking system namely the Islamic banks and consequently give a negative effect on economy where fund stability is crucial for country’s payment system. A deep thought will be more plausible for Islamic banking to offer Wadiah type deposits rather than mudharabah if the lower return persist which is unfair to mudharabah account holders.

The authors’ study on comparison of return on investment in mudharabah and equity was actually not new. There were some other empirical works conducted that compare the return on these two types funds. Rosly and Zaini (2008) compared ROMD and ROE for six Malaysian Islamic banks in 2005 which found that ROE was higher than ROMD that exhibits a behavior similar to that of conventional-fixed deposit. Fixed deposit also used local interest rate as the benchmark to determine the return rate.

Sundarajan (2005) went a step further by examining the relationship among the returns on investment accounts, the returns on bank deposits generally in the banking system, the return on assets (ROA) and equity, and the level of risks. His analysis showed that in practice there is a considerable smoothing of returns on investment account despite wide divergences in risk, and hence very little risk sharing with investment. The “smoothing element” of return seems validated by the research paper authors when they found some Islamic banks have established two types of reserve namely the profit equalization reserve (PER) and the investment risk reserve (IRR). These two reserves could be the contributing factors why returns on mudharabah deposit are always lower than equity.

The result of the research showed that the ROE in the sample tend to be at least two times higher than the ROMD, even though the risk is similar in many aspects. There was also no signicant difference, in respect to the return on mudharabah and equity, between those banks following AAOIFI standards and those who do not.

This research should be followed by a more deep study on creation of an Islamic investment product other than mudharabah deposit that meet the risk and return theory and at the same time practiced as well as observed by Islamic banks. If an investment portfolio is exposed to higher risks, then it should be given higher returns. This is because there are portion of investment communities who are willing to put in their money for more return as long as the investment is Shariah compliant, free from usury and permissible.

Reviewed by: saupee

HOW TO WRITE A REVIEW OF AN ARTICLE

1.       Read the article several times. Begin by looking quickly at the opening statements, headings and opening sentences of each paragraph and the conclusion. Then go back to the beginning and read the article in its entirety. Reading the article a third time with a highlighter or pen in hand allows for making notes or highlighting important sections.

2.       Create a summary outline. This is an outline of the main points made in the article and the supporting research or arguments. It is strictly a restatement of the main points of the article and does not include your opinions.

• Review the summary outline to eliminate unnecessary items. Erase or cross out the less important arguments or supplemental information.

3.       Write an outline of your opinions. Review each item in the summary outline to determine whether the author was accurate and clear. Write down in outline form all instances of effective writing, new contributions to the field, as well as areas of the article that need improvement.

•  Create a list of strengths and weaknesses. The strength of the article may be that it presents a clear summation of a particular issue. Its weakness may be that it does not offer any new information or solutions.

• Use specific examples and references. For example, the article might have incorrectly reported the facts of a popular study. Jot down this observation in your outline and look up the facts of the study to confirm your observation.

4.       Start your review by referring to the title of the article in the first paragraph. Include the name of the author.

5.       Summarize the article. Express the main points and arguments of the article in your own words, referring to your summary outline for assistance. This may be done in several paragraphs, although the length will depend on requirements established by your instructor or publisher.

• Review the summary you have written. Read over your summary several times to ensure that your words are an accurate description of the author's article.

6.       Write the opinion portion of your article review. Use your outline of opinions to write several paragraphs explaining how well the author addressed the topic. Express your opinion about whether the article was a clear, thorough and useful explanation of the subject.

• Use a topic sentence and supportive arguments for each opinion. For example, you might address a particular article strength in the first sentence of the opinion section, followed by several sentences elaborating on the significance of the point.

7.       Conclude the article review. In a paragraph, summarize the main points of the article, as well as your opinions about its significance, accuracy and clarity. If relevant, also comment on implications for further research or discussion in the field.